From the November 2006 issue of Wealth Manager Web • Subscribe!

November 1, 2006

From the Bargain Bins

Small value funds began surging in 2000. For the next six straight years, the group outpaced the Standard & Poor's 500-stock index. The strong showing did not go unnoticed. Investors poured cash into top funds, overwhelming many managers. Now, of the 20 small value funds with the best five-year records, 12 are closed to new investors, according to Morningstar. Several other top performers focus only on institutions. With the gates barred at so many funds, should investors stay on the sidelines and wait until the category moves out of favor? Probably not.

The average small value portfolio sells for a price/earnings ratio of 15.3. The figure doesn't seem excessive, particularly when compared with large value funds, which have a P/E of 13.4. Most often small stocks cost a bit more than large. And as the powerful rally showed, small value stocks can be important diversifiers, sometimes rising when the S&P is stagnating. Even if small value funds are no long screaming bargains, they remain attractive for investors seeking solid long-term holdings.

Which small value selection makes the best choice? To find a winner, we turned again to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks to find funds that are at least three years old and have a minimum of $75 million in assets. At least 80 percent of holdings must be consistent with the category. One- and three-year total returns must exceed category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also top category medians. The expense ratio must fall below the top quartile.

The screens reduced the field from 242 contenders down to 56. The finalist with the top five-year return was Schneider Small Value, but it was closed. Hotchkis and Wiley Small Value, the second place finisher, was also closed. Of the open funds, Pacific Small Cap Y and Principal Investors Small Value had impressive records, but we gave the title to James Small Cap, the top performer of the open funds.

James achieved its strong returns by following a disciplined method that relies heavily on quantitative screens. The fund wants small stocks that have below-average prices as measured by P/Es. James is particularly interested in what it calls neglected companies, stocks that are followed by few Wall Street analysts and not owned by many institutions. Such unloved issues can soar once they are discovered by the crowd.

While neglected companies present opportunities, they can also pose traps; all too often unloved companies face serious business problems. To avoid the losers, portfolio manager Barry James only takes companies that have been reporting growing earnings for the past 12 months. In addition, the stock must have been outperforming the market for the past 12 months. "The aim is to find a cheap stock that is just beginning to be discovered by the market," James says. "If you wait until everyone has discovered it, then it is too late."

As a final check, James looks for signs that management has confidence in its own business. Favorable indicators may be purchases of the stock by insiders. James sometimes finds indicators of confidence in annual reports. "Executives tend to be very circumspect about what they say in annual reports these days," he says. "If the chairman says that he thinks it is going to be a good year, then that is a healthy sign."

James rarely finds stocks that score top marks for all his criteria. That forces him to compromise, taking stocks that rank high only in some areas. Once the computerized screens locate several hundred stocks, human analysts winnow down the field to about 70 holdings for the fund. James aims to keep the final portfolio diversified. He only puts up to 2.5 percent of assets into a stock initially. If the position thrives and grows to 8 percent of assets, he cuts back the stake. The fund seeks to hold a wide selection of industries, not putting more than 25 percent of assets in any one sector.

While the portfolio does spread its bets, James sometimes slightly overweights industries that seem especially cheap. In 2000, he began overweighting energy, a move that proved highly successful. "A few years ago, the energy price-earnings ratios were down in the dirt, but the companies were making money as fast as they could pull oil out of the ground," he says.

Lately the fund is overweighting finance because James figures that interest rates have peaked and will soon be heading down a bit. That will help profits of banks and others who will be able to borrow at lower rates. A favorite financial holding is CNA Surety Corp., an insurer that has a P/E of 11 and occupies growing niches. The company provides specialized coverage for clients who want protection from losses caused by dishonest employees.

Another big holding is Park Electrochemical Corp., which makes printed circuit materials for a wide range of industries. The company should enjoy steady growth from sales to the aerospace industry and high-end computer makers, James says.

Whatever industry he emphasizes, James keeps the fund clearly located in small-cap territory. He never buys any stocks with market capitalizations of greater than $1.5 billion. And once a stock reaches $2 billion, he begins selling the shares. The aim is to continue offering a fund that provides shareholders with a dose of undervalued small stocks that seem likely to rebound.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a business writer and has long been a regular contributor to Wealth Manager.

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